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I receive many enquiries on tax deductibility for interest paid on debt arising from various and sundry transactions. Many of these enquiries take me back to the Singleton case, heard by the Supreme Court of Canada in 2001, and essentially affirmed in the Lipson case, decided by the Supreme Court of Canada in January 2009. Though Lipson was much more complex, with other facets considered by the Court, the basic issue of interest deductibility as decided by Singleton was upheld.

Financial advisors and tax practitioners across the country have always coached their clients to replace non-deductible debt with deductible debt where possible. The test as to whether tax is deductible or not is a question of whether it is deemed to be a legitimate tax planning strategy or abusive tax avoidance -- and whether the General Anti-Avoidance Rules ('GAAR') apply. GAAR permits the CRA to disallow any transaction that is designed for no other legitimate purpose apart from tax reduction. Essentially, GAAR is a 'smell-test' -- if something doesn't quite seem right, the CRA may not allow the deduction, forcing the matter to go before the Courts to be determined.

The good news is that the Supreme Court of Canada held in the Singleton case that the direct use of funds is what counts for interest deductibility, and that GAAR did not apply. This 'direct use of funds' validation meant that advisors could feel much more comfortable in recommending this strategy to even their most conservative clients. This column gives a brief overview of Mr. Singleton's case and explains how it has clarified the situation for investors. This column also addresses recent tax treatment by the Canada Revenue Agency (CRA).

Mr. Singleton, a partner in a law firm, managed to create a transaction to make the interest on his home mortgage tax-deductible. He did this by withdrawing $300,000 from his law firm's capital account and used it to pay his home mortgage. He then borrowed $300,000 from a bank to repay his capital account. Interest on a home mortgage is not tax-deductible. However, the loan to fund the capital account contribution was. It was considered to be borrowing for the purpose of earning business income from the partnership. By doing this Mr. Singleton was able to convert non-deductible interest into deductible interest.

Mr. Singleton originally deducted interest of about $3,700 and $27,000 in 1988 and 1989. The CRA reassessed Mr. Singleton and refused to allow his interest deduction for each of those years. Mr. Singleton appealed to the Tax Court of Canada, which dismissed his appeal. Then he appealed to the Federal Court of Appeal, which agreed with him, setting aside the lower court's decision that the interest was not deductible. The CRA continued to fight the case and took it to the Supreme Court of Canada, which released its judgment in 2001.

The Tax Court of Canada initially found that all the transactions that Mr. Singleton undertook were related. As a result, the Court determined they should be considered as one transaction -- the purchase of the home -- for which interest is not tax deductible. The Court ruled that the money was not borrowed for business purposes as the true purpose of borrowing the money was to buy a home.

The Federal Court of Appeal disagreed. The Federal Court stated "the issue was whether the separate transactions undertaken by Mr. Singleton should be treated as independent transactions or as one transaction." The Court held that the transactions should be considered independently. It found that the interest was deductible because the direct use of the funds was to refinance his capital account in the partnership and was therefore a valid business expense. Mr. Singleton was entitled to deduct his interest expense because he could clearly trace the borrowed funds to a business-earning purpose (i.e. the refinancing of his partnership capital account.)

The Supreme Court of Canada sided with the Appeal Court's reasoning. It stated: "While courts must be sensitive to the economic realities of a transaction and to the general object and spirit of the provision, where the provision at issue is clear and unambiguous, as in this case, its terms must simply be applied. In this case, a direct link can be drawn between the borrowed money and an eligible use, so Singleton was entitled to deduct from his income the relevant interest payments. The transactions in question are properly viewed independently."

As a result of the Supreme Court of Canada's decision, Canadians can sleep a little better knowing their interest claims won't be challenged.

The situation in the Singleton case is very similar to the advice many Canadians receive from their financial planners before buying a home.

Professional advisors often recommend investors liquidate any non-registered investments (stocks, bonds, mutual funds, etc.) and use the cash to reduce their mortgages. Then, the clients can take out an "investment loan" and repurchase the securities previously sold. By doing this, what would have been non-deductible interest on a mortgage has become tax deductible interest on income-producing investments.

Following Singleton, the CRA took the opportunity to release the preliminary results of its review of its position on interest deductibility on income tax.

The preliminary results of the CRA study clearly indicate that the CRA is reading the cases in the same way as the general tax community and has conceded the results in these cases. The following are some highlights from its proposed new position.

One of the key issues relating to the deductibility of interest paid on borrowed money is whether the borrowed money is traceable to a current eligible (that is, income-earning) use.

The CRA indicated that it will adopt a flexible approach to ascertaining the current use of borrowed money where direct tracing of funds is not possible, for example where borrowed money has been commingled with other money. Having said this, you would make life less cumbersome on yourself if you kept your personal debt and your business debt separate.

The CRA will generally accept that a taxpayer has satisfied the test of tracing borrowed money to a current eligible use where the total eligible expenditures from a commingled cash account exceeds the amount of borrowed money deposited to that account.

Where a taxpayer uses borrowed money to acquire a debt or equity investment, the CRA will generally accept that the acquisition has an income-earning purpose and, thus, represents an eligible use. That is, provided that the taxpayer had a reasonable expectation of earning income at the time of acquisition. The CRA acknowledged that income in this context refers to gross income as opposed to net income. The CRA indicated, however, that it has referred this issue to the department of finance for further consideration. Unfortunately, the department of finance has not as yet added meaningful clarity to the subject.

Interest paid on borrowed money used to purchase mutual funds, segregated funds and common shares, etc., will be treated as deductible if there is a reasonable expectation that income will be generated, be it interest or dividend income.

The information in this article is not intended to constitute tax or legal advice, and it may not be relied on for such. Please seek specific professional advice prior to investing.

Please do not hesitate to contact the writer should you require additional information.

* Joel Attis is a Financial Advisor with AttisCorp Financial Group, Inc. in Moncton. Mutual funds are provided through Investia Financial Services Inc. Comments or questions may be submitted to joel@attiscorp.com, or he may be reached at 855-1155.